Most people know about the benefits of having a retirement account.
You get to delay paying income taxes on your contributions (up to the limits), and you can watch your invested nest egg grow over time.
Of course, there is no free lunch, so when you do take the money out in retirement, you’ll have a tax responsibility.
However, hopefully, you’re in a lower tax bracket by the time you reach your golden years.
Before I get into why you should strive to have a Roth IRA, we need to understand the different types of retirement accounts.
Let’s Start with the 401k
If you’re employed, you might have a 401k plan with your company and you probably never see the money that is contributed from each paycheck.
Some companies even match your 401k contribution.
This is free money, and if you are able to take advantage of an employer match, you really should. Who doesn’t like free money?
People that are self-employed with no full-time employees can also open solo 401k accounts. You get the same great benefits of tax savings and investing for retirement.
Like we mentioned before, this account is tax-deferred. This means that you get to reap the tax benefits now, however, you will have to pay taxes on withdraws in retirement.
Now to the IRA
If you’re self-employed, you may have an IRA account. Keep in mind, you don’t have to be self-employed to have an IRA account.
There are a few main types of
Traditional IRA– You can contribute up to $5,500 (for 2018) into a traditional IRA. This contribution is a tax deduction, however, you will owe taxes when you take money out in retirement.
SEP IRA– These are ideal for self-employed individuals. You can contribute up to 25% of your income capped at $55,000 for 2018. This is a hefty deduction if your business is doing well.
Now, lets get into Roth IRA’s and why you need to work towards having one.
We know that a 401k, Traditional IRA or SEP IRA is tax-deferred. So, we get tax savings
A Roth IRA is different in the sense that you fund it with money that you’ve already paid taxes on.
Any gains from your investments in your Roth IRA are tax-free when you pull them out in retirement.
If you contribute the yearly max and invest it, over time your gains could become substantial the earlier you start.
One neat feature of a Roth IRA is you can take out your contributed earnings penalty free before retirement because you’ve already paid taxes on them. So no need to be afraid to get one going.
In contrast, you can not take out the earnings (capital gains) before retirement without a penalty (and taxes).
One exception to this rule is if you’re a first time home buyer. You may be able to use your Roth IRA funds (gains included) up to $10,000 to buy a home.
You’d be able to do this before retirement with no penalty or tax liability if you’ve owned the IRA for 5 years or more.
The first time home buyer is just one of a few exceptions to the rule.
Diversifying your assets is always a good idea to protect yourself from one asset alone destroying your portfolio value.
Why not diversify the way you pay taxes?
You can gain benefits now with tax-deferred accounts.
On the flip side, you can have investments that you won’t have to worry about paying taxes on gains in the future.
If you end up with some really great returns, the tax savings here can be absolutely worth it.
If you contribute the max every year, this growth could be exponential depending on what you invest it in and how the market does over time.
To put it into perspective, historically, the market has returned on average 7% a year after inflation.
If you have many years before you retire, you have time to really let this money grow.
Here is an example:
$5,500 deposited initially
$5,500 deposited at the end of every year for 30 years
Earning 7% compounded annually
This will yield you a whopping $561,401 at the end of 30 years.
Obviously, stock market returns are never guaranteed, however, historically this is how the stock market has performed over time.
You don’t have to contribute the max of $5,500 to a Roth IRA. That is just the maximum the IRS will allow you to (they don’t want to give away too much tax money, of course).
If you only have a little bit to contribute, that’s fine and you can do whatever you can afford.
What to Invest it In
Investing your Roth IRA doesn’t require being a hedge fund genius.
With the rise of ETF’s (funds that are diversified and traded like a stock), you can pretty easily find an ETF that follows the broad stock market such as the S&P 500.
Many brokers like Fidelity or Charles Schwab can help you open your Roth IRA and find investments you’re looking for.
Just know there are a few differences between mutual funds and ETF’s such as cost and when taxable events happen (that is a whole new post).
If you prefer to invest in specific companies, you can do this as well.
If the thought of the stock market makes you nauseous, you may be able to invest in lower risk assets like Certificate of Deposits or Treasury bonds.
Whichever way you chose to invest in your Roth IRA, the earlier you start, the better!